Measuring Loss Aversion under Ambiguity: A Method to Make Prospect Theory Completely Observable

Abstract

We propose a simple, parameter-free method that, for the first time, makes it possible to completely observe Tversky and Kahneman’s (1992) prospect theory. While methods exist to measure event weighting and the utility for gains and losses separately, there was no method to measure loss aversion under ambiguity. Our method allows this and thereby it can measure prospect theory’s entire utility function. Consequently, we can properly identify properties of utility and perform new tests of prospect theory. We implemented our method in an experiment and obtained support for prospect theory. Utility was concave for gains and convex for losses and there was substantial loss aversion. Both utility and loss aversion were the same for risk and ambiguity, as assumed by prospect theory, and sign-comonotonic trade-off consistency, the central condition of prospect theory, held.

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Acknowledgments

We gratefully acknowledge helpful comments from Aurélien Baillon, Ferdinand Vieider, Peter P. Wakker, Horst Zank, and an anonymous reviewer and financial support from the Erasmus Research Institute of Management, the Netherlands Organisation for Scientific Research (NWO), the Tinbergen Institute, Rennes Metropole district (AIS_2013), and the Economic and Social Research Council via the Network for Integrated Behavioral Sciences (award n. ES/K002201/1).

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